Question

How do propensities and multipliers, and even expectations affect the outcomes? ATLEAST 300 words

Answer 1

The multiplier effect refers to the increase in final income arising from any new of spending.

Every time there is an booster of new demand into the circular flow of income there is likely to be a multiplier effect. This is because an injection of extra income leads to more spending, which creates more income, and so on.

The size of the multiplier depends upon household’s marginal decisions to spend, called the marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps).

It is important to remember that when income is spent, this spending becomes someone else’s income, and so on. Marginal propensities show the proportion of extra income allocated to particular activities, such as investment spending by firms, saving by households, and spending on imports from abroad.

For example, if 80% of all new income in a given period of time is spent on products, the marginal propensity to consume would be 80/100, which is 0.8.

The following general formula to calculate the multiplier uses marginal propensities, as follows:

11 – mpc

Hence, if consumers spend 0.8 and save 0.2 of every 1 of extra income, the multiplier will be:

11 – 0.8=10.2=5

Hence, the multiplier is 5, which means that every 1 of new income generates 5 of extra income.

The multiplier effect in an open economy

As well as calculating the multiplier in terms of how extra income gets spent, we can also measure the multiplier in terms of how much of the extra income goes in savings, and other withdrawals. A full ‘open’ economy has all sectors, and therefore, three withdrawals – savings, taxation and imports.

This is indicated by the marginal propensity to save (mps) plus the extra income going to the government – the marginal tax rate (mtr) plus the amount going abroad – the marginal propensity to import (mpm).

By adding up all the withdrawals we get the marginal propensity to withdraw (mpw). The multiplier can now be calculated by the following general equation:

11 – mpw